The Surreal, Ironic Story Behind California’s Retroactive Tax on Small Business Investors

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A major tax incentive designed to encourage investors to back startups and other small businesses in California has just evaporated. If you sold stock in a so-called “qualifying small business” (QSB) in 2012, you won’t be able to exclude or defer any of your gains when you fill out your state income tax return this spring, as you formerly could under California law.

That may sound like a relatively minor matter, especially if you don’t own startup shares or aren’t an active investor. And in light of California’s financial woes, it would certainly be intellectually understandable if the state had decided to drop the exemption going forward. But the changes don’t stop there. Under the California Franchise Tax Board’s interpretation of a 2012 state Court of Appeals ruling, which found part of the tax law to be unconstitutional, anyone who acted in good faith to claim the now-deceased QSB incentive on their 2011 California return owes the state back taxes on the excluded or deferred income.

And the same goes for 2010. And 2009. And 2008.

And, what’s more, these taxpayers will also be hit with back interest and possible penalties.

If you’re unsettled by the idea of owing additional taxes, interest, and maybe penalties on a completely legitimate return you submitted four years ago, you aren’t alone. “These taxpayers followed the law when they filed their tax returns,” says Gina Rodriquez, vice president of tax policy at the California Taxpayers Association, a non-profit advisory organization in Sacramento. “For [the Franchise Tax Board] to come out four or five years later and say, ‘You followed the law, but it was unconstitutional, and now we are going to hit you with back taxes and interest’—and the interest can be huge—that is just not fair tax policy.”

The retroactive nature of the tax change, which was announced by the Franchise Tax Board on the eve of the Christmas holiday, has taken plenty of California taxpayers by surprise. In fact, the changes went largely unremarked outside a small community of accountants and tax attorneys until Xconomy published a guest editorial about the FTB notice by Brian Overstreet, the co-founder of drug safety monitoring startup AdverseEvents.com, on Jan. 15.

Since that article appeared, the FTB’s retroactive clawback decision has begun to generate national press coverage, not to mention pained outcries from many other California entrepreneurs and investors. It’s unclear exactly how many taxpayers will ultimately be affected: the FTB puts the number at just 500 people per tax year, or as many as 2,500 altogether, who might owe a cumulative $150 million in back taxes, while Los Angeles law firm Manatt, Phelps & Phillips says the impact could be much larger, affecting “countless taxpayers” who have claimed the QSB exclusions since 2008.

But regardless of the exact number of people now in line to receive tax bills from the FTB, the change is sparking angry protest from critics who say the tax board overreacted to the Court of Appeals ruling and didn’t need to make the remedy retroactive. Moreover, observers in the tax and investing communities say the reversal of the QSB incentive—coming on the heels of big income tax increases imposed by Proposition 30, which voters approved in November—could erode the state’s image as a haven for innovators, ultimately driving investors and entrepreneurs to take their money and their talent to other states with lower income tax rates.

“Whether it’s the QSB stuff, or whether it’s Proposition 30, all of it is part of a pattern, and the cumulative impact is chilling,” says Bob Ackerman, founder of San Francisco-based venture firm Allegis Capital. “I have had conversations with a number of entrepreneurs as well as a number of venture firms who have indicated that they are seriously rethinking where they invest and where they build companies.”

In the court case that prompted the change, the FTB argued that California has the prerogative to use tax incentives to encourage in-state investing. (The specific issue in the case was whether the incentives were set up in a way that discriminated against taxpayers who invested in multi-state businesses.) Observers say it’s ironic that the board has now gone to the opposite extreme—not just nullifying the QSB incentives for 2012 and future tax years, but penalizing taxpayers who took advantage of them before 2012.

But there may be an even bigger irony in the episode: the plaintiffs who originally argued that the tax incentives were unconstitutional—and who persuaded the Court of Appeals to agree—say the FTB’s response is the opposite of what they’d hoped for.

“It’s throwing the baby out with the bathwater,” says Marty Dakessian, an attorney at law firm ReedSmith who represented private investor Frank Cutler in the decade-long case. “We thought the appellate court decision would be a big win for taxpayers. By ending the discriminatory nature of the incentive, it should have expanded the pool of startups and small businesses that qualified for the benefits. But we were taken aback by the FTB’s approach. You would have hoped that they would recognize the intent of the legislation, which was to encourage investment and foster the entrepreneurial spirit and innovation in the private sector—all the things that people in Sacramento love to talk about.”

In interviews with investors, entrepreneurs, lawyers, and tax policy analysts, Xconomy has reconstructed the complex history of Cutler v. Franchise Tax Board and the FTB’s response to the appellate court decision. We asked sources what other options might have been available to the FTB after the ruling; what ripples the decision is likely to send through California’s innovation ecosystem; and whether opposition to the new policy might snowball into some kind of organized political response. For the details, read on.

Property, Payroll, and the Commerce Clause

A tax change that could end up costing technology investors hundreds of millions of dollars began 15 years ago when one man, Newport Beach resident Frank Cutler, sold some of his stock in a high-flying Silicon Valley startup, US Web.

One of the first big Web design, marketing, and hosting companies, US Web went public in December 1997. In 1998, Cutler, an early investor and board member at the company, sold shares worth about $2.3 million. (This and other details of the case are spelled out in the Aug. 28 ruling by the California Second District Court of Appeal, which was written by Associate Justice Elizabeth Grimes.)

Cutler rolled some of the money from the stock sale into three other small businesses, and on his 1998 state income tax return, he deferred that portion of the gain—that is, he didn’t report it as income. California’s tax code provided for just such a scenario: individuals were allowed to … Next Page »